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(2) “Liquidity Preference”
Those Keynesians who recognize the grave difficulties of their system fall back on one last string in their bow—”liquidity preference.” Intelligent Keynesians will concede that involuntary unemployment is a “special” or rare case, and Lindahl goes even further to say that it could be only a short-run and not a long-run equilibrium phenomenon.19 Neither Modigliani nor Lindahl, however, is thoroughgoing enough in his critique of the Keynesian system, particularly of the “liquidity preference” doctrine.
The Keynesian system, as is quite clear from the mathematical portrayals of it given by its followers, suffers grievously from the mathematical-economic sin of “mutual determination.” The use of mathematical functions, which are reversible at will, is appropriate in physics, where we do not know the causes of the observed movements. Since we do not know the causes, any mathematical law explaining or describing movements will be reversible, and, as far as we are concerned, any of the variables in the function is just as much “cause” as another. In praxeology, the science of human action, however, we know the original cause—motivated action by individuals. This knowledge provides us with true axioms. From these axioms, true laws are deduced. They are deduced step by step in a logical, cause-and-effect relationship. Since first causes are known, their consequent effects are also known. Economics therefore traces unilinear cause-and-effect relations, not vague “mutually determining” relations.
This methodological reminder is singularly applicable to the Keynesian theory of interest. For the Keynesians consider the rate of interest (a) as determining investment and (b) as being determined by the demand for money to hold “for speculative purposes” (liquidity preference). In practice, however, they treat the latter not as determining the rate of interest, but as being determined by it. The methodology of “mutual determination” has completely obscured this sleight of hand. Keynesians might object that all demand and supply curves are “mutually determining” in their relation to price. But this facile assertion is not correct. Demand curves are determined by utility scales, and supply curves by speculation and the stock produced by given labor and land factors, which is ultimately governed by time preferences.
The Keynesians therefore treat the rate of interest, not as they believe they do—as determined by liquidity preference—but rather as some sort of mysterious and unexplained force imposing itself on the other elements of the economic system. Thus, Keynesian discussion of liquidity preference centers around “inducement to hold cash” as the rate of interest rises or falls. According to the theory of liquidity preference, a fall in the rate of interest increases the quantity of cash demanded for “speculative purposes” (liquidity preferences), and a rise in the rate of interest lowers liquidity preference.
The first error in this concept is the arbitrary separation of the demand for money into two separate parts: a “transactions demand,” supposedly determined by the size of social income, and a “speculative demand,” determined by the rate of interest. We have seen that all sorts of influences impinge themselves on the demand for money. But they are only influences working through the value scales of individuals. And there is only one final demand for money, because each individual has only one value scale. There is no way by which we can split the demand up into two parts and speak of them as independent entities. Furthermore, there are far more than two influences on demand. In the final analysis, the demand for money, like all utilities, cannot be reduced to simple determinants; it is the outcome of free, independent decisions on individual value scales. There is, therefore, no “transaction demand” uniquely determined by the size of income.
The “speculative demand” is mysterious indeed. Modigliani explains this “liquidity preference” as follows:
we should expect that any fall in the rate of interest ... would induce a growing number of potential investors to keep their assets in the form of money, rather than securities; that is to say, we should expect a fall in the rate of interest to increase the demand for money as an asset.20
This is subject to the criticism, as we have seen, that the rate of interest is here determining, and is not itself explained by any cause. Furthermore, what does this statement mean? A fall in the rate of interest, according to the Keynesians, means that less interest is being earned from bonds, and therefore there is a greater inducement to hold cash. This is correct (as long as we allow ourselves to think in terms of the interest rate as determining instead of being determined), but highly inadequate. For if a lower interest rate “induces” greater cash holdings, it also induces greater consumption, since consumption also becomes more attractive. In fact, one of the grave defects of the liquidity-preference approach is that the Keynesians never think in terms of three “margins” being decided at once. They think only in terms of two at a time. Hence, Modigliani: “Having made his consumption-saving plan, the individual has to make decisions concerning the assets he owns”; i.e., he then allocates them between money and securities.21 In other words, people first decide between consumption and saving (in the sense of not consuming); and then they decide between investing and hoarding these savings. But this is an absurdly artificial construction. People decide on all three of their alternatives, weighing one against each of the others. To say that people first decide between consuming and not consuming and then choose between hoarding and investing is just as misleading as to say that people first choose how much to hoard and then decide between consumption and investment.22
People, therefore, allocate their money among consumption, investment, and hoarding. The proportion between consumption and investment reflects individual time preferences. Consumption reflects desires for present goods, and investment reflects desires for future goods. An increase in the demand-for-money schedule does not affect the rate of interest if the proportion between consumption and investment (i.e., time preference) remains the same.
The rate of interest, we must reiterate, is determined by time preferences, which also determine the proportions of consumption and investment. To think of the rate of interest as “inducing” more or less saving or hoarding is to misunderstand the problem completely.23
Admitting, then, that time preference determines the proportions of consumption and investment and that the demand for money determines the proportion of income hoarded, does the demand for money play a role in determining the interest rate? The Keynesians assert that there is a relation between the rate of interest and a “speculative” demand for cash. Should the schedule of the latter rise, the former rises also. But this is not necessarily true. A greater proportion of funds hoarded can be drawn from three alternative sources: (a) from funds that formerly went into consumption, (b) from funds that went into investment, and (c) from a mixture of both that leaves the old consumption-investment proportion unchanged. Condition (a) will bring about a fall in the rate of interest; condition (b) a rise in the rate of interest, and condition (c) will leave the rate of interest unchanged. Thus hoarding may reflect either a rise, a fall, or no change in the rate of interest, depending on whether time preferences have concomitantly risen, fallen, or remained the same.
The Keynesians contend that the speculative demand for cash depends upon and determines the rate of interest in this way: if people expect that the rate of interest will rise in the near future, then their liquidity preference increases to await this rise. This, however, can hardly be a part of a long-run equilibrium theory, such as Keynes is trying to establish. Speculation, by its very nature, disappears in the ERE, and hence no fundamental causal theory can be based upon it. Furthermore, what is an interest rate? One grave and fundamental Keynesian error is to persist in regarding the interest rate as a contract rate on loans, instead of the price spreads between stages of production. The former, as we have seen, is only the reflection of the latter. A strong expectation of a rapid rise in interest rate means a strong expectation of an increase in the price spreads, or rate of net return. A fall in prices means that entrepreneurs generally expect that factor prices will fall further in the near future than their selling prices. But it requires no Keynesian labyrinth to explain this phenomenon; all we are confronted with is a situation in which entrepreneurs, expecting that factor prices will soon fall, cease investing and wait for this happy event so that their return will be greater. This is not “liquidity preference,” but speculation on price changes. It involves a modification of our previous discussion of the relation between prices and the demand for money, caused by a fact that we shall explore soon in detail, namely, that prices do not change equally and proportionately.
The expectation of falling factor prices speeds up the movement toward equilibrium and hence toward the pure interest relation as determined by time preference.24
If, for example, unions keep wage rates artificially high, “hoarding” will increase as unions keep wage rates ever higher than the equilibrium rate at which “full employment” can be maintained. This induced hoarding lowers the money demand for factors and increases unemployment still further, but only because of wage-rate rigidity.25
The final Keynesian bogey is that people may acquire an unlimited demand for money, so that hoards will indefinitely increase. This is termed an “infinite” liquidity preference. And this is the only case in which neo-Keynesians such as Modigliani believe that involuntary unemployment can be compatible with price and wage freedom. The Keynesian worry is that people will hoard instead of buying bonds for fear of a fall in the price of securities. Translating this into more important “natural” terms, this would mean, as we have stated, not investing because of expectation of imminent increases in the natural interest rate. Rather than act as a blockade, however, this expectation speeds the ensuing adjustment. Furthermore, the demand for money could not be infinite since people must always continue consuming, whatever their expectations. Of necessity, therefore, the demand for money could never be infinite. The existing level of consumption, in turn, will require a certain level of investment. As long as productive activities are continuing, there is no need or possibility of lasting unemployment, regardless of the degree of hoarding.26
A demand for money to hold stems from the general uncertainty of the market. Keynesians, however, attribute liquidity preference, not to general uncertainty, but to the specific uncertainty of future bond prices. Surely this is a highly superficial and limiting view.
In the first place, this cause of liquidity preference could occur only on a highly imperfect securities market. As Lachmann pointed out years ago in a neglected article, Keynes’ causal pattern—“bearishness” causing “liquidity preference” (demand for cash) and high interest rates—could take place only in the absence of an organized forward or futures market for securities.
If such a market existed, both bears and bulls on the bond market
could express their expectations by forward transactions which do not require any cash. Where the market for securities is fully organized over time, the owner of 4% bonds who fears a rise in the rate of interest has no incentive to exchange them for cash, for he can always “hedge” by selling them forward.27
Bearishness would cause a fall in forward bond prices, followed immediately by a fall in spot prices. Thus, speculative bearishness would, of course, cause at least a temporary rise in the rate of interest, but accompanied by no increase in the demand for cash. Hence, any attempted connection between liquidity preference, or demand for cash, and the rate of interest, falls to the ground.
The fact that such a securities market has not been organized indicates that traders are not nearly as worried about rising interest rates as Keynes believes. If they were and this fear loomed as an important phenomenon, then surely a futures market would have developed in securities.
Furthermore, as we have seen, interest rates on loans are merely a reflection of price spreads, so that a prediction of higher interest rates really means the expectation of lower prices and, especially, lower costs, resulting in a greater demand for money. And all speculation, on the free market, is self-correcting and speeds adjustment, rather than a cause of economic trouble.
- 19. Cf. Lindahl's critique of Lawrence Klein's The Keynesian Revolution in “On Keynes’ Economic System—Part I,” p. 162. Also see Leontief, “Postulates: Keynes’ General Theory and the Classicists.”
- 20. Modigliani, “Liquidity Preference and the Theory of Interest and Money,” pp. 139–40.
- 21. Ibid., p. 137.
- 22. See the critique of the Keynesian doctrine by Tjardus Greidanus, The Value of Money (2nd ed.; London: Staples Press, 1950), pp. 194–215, and of the liquidity-preference theory by D.H. Robertson, “Mr. Keynes and the Rate of Interest” in Readings in the Theory of Income Distribution, pp. 439–41. In contrast to Keynes’ famous phrase that the rate of interest is “the reward for parting with liquidity,” Greidanus points out that buying consumers’ goods (or even producers’ goods in Keynes’ sense of “interest”) sacrifices liquidity and yet earns no interest “reward.” Greidanus, Value of Money, p. 211. Also see Hazlitt, Failure of the “New Economics,” pp. 186 ff.
- 23. Mises, Human Action, pp. 529–30.
- 24. Hutt concludes that equilibrium
is secured when all services and products are so priced that they are (i) brought within the reach of people's pockets (i.e., so that they are purchasable by existing money incomes) or (ii) brought into such a relation to predicted prices that no postponement of expenditure on them is induced. For instance, the products and services used in the manufacture of investment goods must be so priced that anticipated future money incomes will be able to buy the services and depreciation of new equipment or replacement. (Hutt, “Significance of Price Flexibility,” p. 394)
- 25. “Postponements (in purchases) arise because it is judged that a cut in costs (or other prices) is less than will eventually have to take place, or because the rate of fall of costs is insufficiently rapid.” Ibid., p. 395.
- 26. As Hutt points out, if we can conceive of a situation of infinitely elastic liquidity preference (and no such situation has ever existed), then “we can conceive of prices falling rapidly, keeping pace with expectations of price changes, but never reaching zero, with full utilization of resources persisting all the way.” Ibid., p. 398.
- 27. L.M. Lachmann, “Uncertainty and Liquidity Preference,” Economica, August, 1937, p. 301.